Fed Watch Thread

[flow5]

IORs are the functional equivalent of required reserves (i.e., they are contractionary; & as such, were used to offset Bernanke’s liquidity funding programs (expansions), on the asset side of the FED’s balance sheet).

If IORs weren't the functional equivalent of required reserves, and didn't absorb other commercial banking system deposits, IORs could not then be used as a monetary policy tool to regulate the money supply (via the FED's preferred monetary transmission mechanism - interest rates).

The "money multiplier" used by the St. Louis is not, and has never been, a base for the expansion of new money & credit (currency has no expansion coefficient). Legal reserves were that base (i.e., total reserves = (excess + ((required) - nonborrowed & borrowed)). Now, only required reserves remotely qualify as a proxy for an expansion coefficient (but nowadays reserve requirements are no longer "binding" - except for the largest commercial banks). I.e., excess reserves are now bank earning assets (at all times, idle & unused by definition). Unfortunately, a money multiplier cannot simultaneously exist in a situation where both (1) the FED pegs interest rates, & (2) the banks aren't reserve constrained.

The protracted problem is that the Federal Reserve doesn’t gauge the volume and timing of its open market operations in terms of the amount and desired rate of increase of member commercial banks costless legal reserves, but rather in terms of the level of the federal funds policy rate (the interest rate banks charge other banks on excess balances with the Federal Reserve), in conjunction with the interest rate the BOG pays the member banks on excess reserve balances at the 12 District Reserve banks (theoretically a floor).

By using the wrong criteria (interest rates, rather than member bank reserves) in formulating and executing monetary policy, the Federal Reserve will remain an engine of inflation.

Numerous testimonies exhibit this mis-understanding: e.g., Governor Laurence H. Meyer "In the early 1980s, for example, the Federal Reserve used a RESERVE QUANTITY PROCEDURE to control the growth of the monetary aggregate M1". Actually "monetarism" hasn't been tried.

The truth for Volcker's experiment was that one dollar of borrowed reserves provided the same legal-economic base for bank credit expansion, as one dollar of non-borrowed reserves did. Back then, at times, 10 percent of all reserves were borrowed. Thus total reserves expanded at a 17% annual rate from the introduction of the DIDMCA until Dec. month-end. This truth is demonstrated by the spectacular example (historical high), in the level of borrowed reserves on Oct 15 2008 of $437b. Otherwise, according to Chairman Paul Volcker "Relatively large borrowing (by the banks from the Fed) exerts a lot of restraint.", i.e., represents a "tight" monetary policy.

Economists should realize that IORs absorb savings, and that savings held by the commercial banks are actually impounded within the System. And that the commercial banking system has caused disintermediation (where the Shadow Banking System shrinks in size, but the size of the CBs remains the same).

More and more lending and investment is being financed thru the Commercial & the Reserve Banks where savings cannot be matched with investment. The correct paradigm is 1966.

[flow5]

MONETARISM HAS NEVER BEEN TRIED:

To counter what Greenspan described as “irrational exuberance (at the height of the Doc.com stock market bubble), Greenspan initiated a "tight" monetary policy (for 31 out of 34 months). A “tight” money policy is one where the rate-of-change in monetary flows (our means-of-payment money times its transactions rate-of-turnover) is no greater than 2-3% above the rate-of-change in the real output of goods & services.

Greenspan then wildly reversed his “tight” money policy (at that point Greenspan was well behind the employment curve), and reverted to a very "easy" monetary policy -- for 41 consecutive months (despite 17 raises in the FFR, -every single rate increase was “behind the curve”). I.e., the evidence shows that: (using a 3 qtr rate-of-change), nominal gDp progressively increased until it finally peaked in the 1st qtr of 2006.

Then, as soon as Bernanke was appointed to the Chairman of the Federal Reserve, he initiated a "tight" money policy (ending the housing bubble in 2006), for 29 consecutive months (out of a possible 29, or at first, sufficient to wring inflation out of the economy, but persisting until the economy collapsed).

I.e., Bernanke didn’t initiate an “easy” money policy until Lehman Brothers filed for bankruptcy protection (& it was one the Federal Reserve Bank of New York’s primary dealers in the Treasury Market) & AIG’s credit rating was lowered (necessitating a $85b . unique credit facility by the FED).

The FOMC continued to drain liquidity (I.E., CONTINUED TO DRAIN LEGAL RESERVES), despite its 7 reductions in the FFR (which began on 9/18/07). I.e., despite Bear Sterns two hedge funds that collapsed, the FED maintained its “tight” money policy.

And for the last 19 successive months (since Aug 2008), the FED has been on a monetary binge (ending at April’s month).

Did you catch it??? Nobody got it. Greenspan didn't start "easing" on January 3, 2000, when the FFR was first lowered by 1/2, to 6%. Greenspan didn't change from a "tight" monetary policy, to an "easier" monetary policy, until after 11 reductions in the FFR, ending just before the reduction on November 6, 2002 @ 1 & 1/4%.

I.e., Greenspan was responsible for both high employment (June 2003, @ 6.3%), and high inflation (rampant real-estate speculation, followed by widespread commodity speculation – peaking in July 2008 – Greenspan’s inflection point).

Bernanke then drove the economy relentlessly into our Depression creating an unemployment rate nightmare of 10.1%.

The problem is that the Federal Reserve doesn’t gauge the volume and timing of its open market operations in terms of the amount and desired rate of increase of member commercial banks costless legal reserves, but rather in terms of the levels of the federal funds rates (the interest rates banks charge other banks on excess balances with the Federal Reserve).

By using the wrong criteria (interest rates, rather than member bank reserves) in formulating and executing monetary policy, the Federal Reserve became an engine of inflation.

================================

2000 jan ……. -0.08 ……. 0.01 top
……. feb ……. -0.06 ……. -0.04
……. mar ……. -0.13 ……. -0.12
……. apr ……. -0.13 ……. -0.04
……. may ……. -0.07 ……. 0
……. jun ……. -0.12 ……. -0.06
……. jul ……. -0.1 ……. -0.05
……. aug ……. -0.11 ……. -0.03
……. sep ……. -0.11 ……. -0.04
……. oct ……. -0.12 ……. -0.07
……. nov ……. -0.12 ……. -0.11
……. dec ……. -0.14 ……. -0.09
2001 jan ……. -0.14 ……. 0
……. feb ……. -0.14 ……. -0.04
……. mar ……. -0.13 ……. -0.11
……. apr ……. -0.12 ……. -0.02
……. may ……. -0.12 ……. -0.01
……. jun ……. -0.1 ……. -0.04
……. jul ……. -0.07 ……. 0
……. aug ……. -0.06 ……. 0.02
……. sep ……. -0.05 ……. 0.03
……. oct ……. 0.11 ……. 0.18
……. nov ……. -0.02 ……. 0.01
……. dec ……. -0.02 ……. 0.04
2002 jan ……. -0.01 ……. 0.16
……. feb ……. 0 ……. 0.1
……. mar ……. 0.01 ……. 0.01
……. apr ……. 0.01 ……. 0.07
……. may ……. -0.04 ……. 0.03
……. jun ……. -0.03 ……. -0.03
……. jul ……. -0.02 ……. -0.02
……. aug ……. -0.01 ……. -0.13
……. sep ……. -0.02 ……. -0.04
……. oct ……. -0.02 ……. -0.06 bottom
……. nov ……. -0.01 ……. -0.11
……. dec ……. 0.02 ……. -0.07
2003 jan ……. 0.07 ……. 0.06
……. feb ……. 0.05 ……. 0.01
……. mar ……. 0.07 ……. 0
……. apr ……. 0.06 ……. 0.06
……. may ……. 0.05 ……. 0.06
……. jun ……. 0.08 ……. 0.05
……. jul ……. 0.1 ……. 0.12
……. aug ……. 0.1 ……. 0.14
……. sep ……. 0.11 ……. 0.15
……. oct ……. -0.05 ……. 0.09
……. nov ……. 0.06 ……. 0
……. dec ……. 0.05 ……. 0.03
2004 jan ……. 0.04 ……. 0.13
……. feb ……. 0.04 ……. 0.08
……. mar ……. 0.09 ……. 0.05
……. apr ……. 0.11 ……. 0.1
……. may ……. 0.14 ……. 0.07
……. jun ……. 0.17 ……. 0.03
……. jul ……. 0.18 ……. 0.04
……. aug ……. 0.15 ……. 0.06
……. sep ……. 0.19 ……. 0.08
……. oct ……. 0.18 ……. 0.06
……. nov ……. 0.16 ……. -0.01
……. dec ……. 0.17 ……. 0.04
2005 jan ……. 0.18 ……. 0.15
……. feb ……. 0.13 ……. 0.03
……. mar ……. 0.13 ……. -0.01
……. apr ……. 0.13 ……. 0.03
……. may ……. 0.12 ……. 0
……. jun ……. 0.11 ……. 0.01
……. jul ……. 0.07 ……. 0
……. aug ……. 0.02 ……. -0.01
……. sep ……. 0.01 ……. 0
……. oct ……. 0.01 ……. -0.05
……. nov ……. 0.02 ……. -0.14
……. dec ……. 0.04 ……. -0.05
2006 jan ……. 0.04 ……. 0.03
……. feb ……. 0.01 ……. -0.04
……. mar ……. -0.02 ……. -0.08 top
……. apr ……. -0.03 ……. -0.03
……. may ……. -0.02 ……. -0.02
……. jun ……. -0.01 ……. 0
……. jul ……. -0.03 ……. 0
……. aug ……. -0.06 ……. -0.02
……. sep ……. -0.08 ……. -0.03
……. oct ……. -0.08 ……. -0.06
……. nov ……. -0.06 ……. -0.11
……. dec ……. -0.07 ……. -0.04
2007 jan ……. -0.11 ……. 0.05
……. feb ……. -0.09 ……. -0.04
……. mar ……. -0.11 ……. -0.1 bottom
……. apr ……. -0.09 ……. -0.05
……. may ……. -0.05 ……. -0.01
……. jun ……. -0.05 ……. 0.02
……. jul ……. -0.08 ……. 0.01
……. aug ……. -0.07 ……. 0
……. sep ……. -0.07 ……. 0 top
……. oct ……. -0.04 ……. -0.03
……. nov ……. -0.04 ……. -0.06
……. dec ……. -0.04 ……. 0
2008 jan ……. -0.07 ……. 0.08
……. feb ……. -0.05 ……. 0
……. mar ……. -0.04 ……. -0.07
……. apr ……. -0.03 ……. -0.01
……. may ……. -0.01 ……. 0.05
……. jun ……. -0.04 ……. 0.04
……. jul ……. -0.03 ……. 0.04
……. aug ……. 0.02 ……. 0.05
……. sep ……. 0.04 ……. 0.05
……. oct ……. 0.17 ……. 0.14
……. nov ……. 0.24 ……. 0.19
……. dec ……. 0.3 ……. 0.31
2009 jan ……. 0.45 ……. 0.57
……. feb ……. 0.4 ……. 0.39
……. mar ……. 0.38 ……. 0.25 bottom
……. apr ……. 0.4 ……. 0.38
……. may ……. 0.47 ……. 0.49

SEE THE PERIOD (first column): FEB 2006 THRU SEPT 2008

[flow5]

The Volcker Rule Study: Key Takeaways Posted by Economics of Contempt at 1:28 AM

"As I expected, the FSOC’s Volcker Rule study (pdf) doesn’t provide a ton of guidance on the key issues, which are the definitions. It does provide some clues though. I don’t have a ton of time, but here’s what I think are some of the key takeaways:

1. Market-making troubles: Regulators are clearly having trouble figuring out how to define “market-making” for less liquid markets such as swaps. Just look at how vague the “indicia of market-making” they identify for less liquid markets are (on page 29). For instance, they identify “Holding oneself out as willing and available to provide liquidity on both sides of the market” as indicative of market-making. Um, ya think?

2. Inventory accumulation will be a problem: The fact that the statute explicitly permits the accumulation of inventory in anticipation of “reasonably expected near term demands of clients” is going to be a serious problem. The study doesn’t include any ideas for how to place meaningful limits on that exemption.

3. Risk-mitigating hedging activity: The FSOC did actually offer some specifics on how they think regulators should define “risk-mitigating hedging activities.” From page 30 of the study:

Risk-mitigating hedging is defined by two essential characteristics: (i) the hedge is tied to a specific risk exposure, and (ii) there is a documented correlation between the hedging instrument and the exposure it is meant to hedge with a reasonable level of hedge effectiveness at the time the hedge is put in place.
The second prong has the potential to be a major flashpoint. If regulators insist that the effectiveness and proper correlations of hedges that fall under this exemption be rigorously documented, then I could see some real wars breaking out between the banks and regulators over whether a given trade is a legitimate hedge. That would be interesting.

4. Do members of the FSOC read my blog? Maybe. (Probably not.) In an earlier post on the Volcker Rule, I noted that the definition of “trading account” in the statute is very similar to the language used in accounting standards, and I wrote that, as a result,

it’s possible that banks could put on prop trades outside of a “trading account” as long as they agree to use a different accounting treatment for the prop trades. And what if accounting standards change? What if FAS 115 is overhauled in the future? What happens to the definition of “trading account” then?

Also, are we talking about the account where the trade originated? What if a trade is originated in the “banking book,” and then subsequently transferred to the trading book? Since the banking book is (obviously) not a “trading account,” it’s not clear if the trade is still prohibited.

Now look at what the FSOC study recommends with regard to the “trading account” issue: (emphasis mine)

To the extent that Agencies choose to incorporate some type of accounting or similar term in defining “trading account,” the Council recommends that Agencies carefully consider how they might ensure that the prohibition on proprietary trading cannot be avoided through changes in accounting designations (e.g., by designating a position as “available for sale” rather than “trading”). Additionally, if accounting standards are used as the basis for the definition of “trading account” for purposes of the Volcker Rule, it is important that Agencies monitor changes to those accounting standards. (pg. 25)"

[flow5]

The Unsustainable Meets the Irresistible

State and local spending is the second biggest component of the economy. The chart below, from David’s letter this week, gives us a visual image of just how large it is. Note that budget deficits at the state and local levels total more than 1% of GDP. Revenues, though, are still off 10% (on average) from where they were at the peak. The “fiscal stimulus” from the US government has run out and states and local communities are having to balance their budgets the old-fashioned way – through spending cuts and increased taxes.

As this budget cutting works its way through the economy, and as inventories are no longer being built (they are already at adequate levels), the growth from the current stimulus (both QE2 and payroll and federal government expenditures) the economy will have to stand on its own in terms of organic growth. And as the year wears on it will become apparent there is less true organic growth than currently meets the eye.

State and Local Spending
A few more thoughts on state and local spending. First, Congress needs to go ahead and authorize a bill allowing states to file for bankruptcy. At the very least, this sends a very clear message to the states that the federal government will not come to their aid. It is not fair to ask states that have done what they need to do to keep their fiscal houses in order, to support states that have overspent, typically by trying to fund their pensions and run other well-intentioned but underfunded programs.

Second, states need the ability to force public unions to come to the table. Many states have overpromised, and they are simply in a very deep hole and need concessions. Private workers have had to take the brunt of the recent crisis, and meanwhile government workers get far more on average than private employees.


You can see in the next graph that this differential has built up over time. It used to be that a federal government job paid less but was more secure. Now it is still more secure but pays about 44% more on average (35% higher wages and 69% higher benefits). (Source: Reason magazine)

Further, while there has been a clear drop in private employment, we have seen 10% growth in federal employment (state and local employment was flat through the middle of last year, but is likely to fall this year, with budget cuts).

That clearly implies there is room at the federal level for some “austerity.” The calls for a rollback to the budget and employment levels of 2007 will become more vocal as the set of facts we will address in a moment become evident.

Before we get to that, however, I want to take a side trip. Illinois recently passed a very real tax increase as a way to start the process of dealing with its massive deficits. It did so in a lame duck session of its state legislature, even though the voters had clearly elected a far more fiscally conservative legislature that would not have passed the tax increases.

The response of the governors of Indiana and Wisconsin, their closest neighbors? They immediately suggested to Illinois businesses that they are welcome to come to their states and set up shop and pay less taxes.

Higher taxes are hardly a cure. Look at the migration of businesses from high-tax states to low-tax states. Over the last ten years it has been pronounced. For those who argue that higher marginal taxes don’t make a difference, the facts clearly overrule you. Oregon decided to tax the wealthiest 2% of its citizens. They collected 40% less than they projected, and over 25% of the people they expected to tax somehow “disappeared.” And that is just in the first year. At some point, the “rich” get tired of being in the crosshairs of politicians and repair to more favorable climes.

This is all part of the national conversation we need to have on taxes and spending. That we need a complete tax overhaul, a thorough rethinking of how we raise the monies we need, should be obvious.

America, they assert, is in a fiscal trap due to the low interest rates we currently enjoy. What if I told you we could cut defense and discretionary spending by 20%, put in a two-year pay freeze on federal employees, and go ahead and let the Bush tax cuts on the “rich” expire. Wouldn’t that go a long way to fixing the deficit? The answer is, sadly, likely to be no.

As the table shows, if interest rates go back to their long-term historical average, spending could rise by $800 billion in just 8 years. Even under the more optimistic assumptions of the Congressional Budget Office, it is still $500+ billion. The government debt held by the public would be around 120% of GDP (back of my napkin), or close to what I said last week was completely unsustainable by the Irish. It will be no less so for the US. Spend a few moments with the table, and see how even deep cuts and freezes have so little impact. That is not to say they are not necessary, but this just shows that a much different approach is needed.


seekingalpha.com/article/247988-u-s-fiscal-situation-the-unsustainable-meets-the-irresistible?source=email_partial_daily_dispatch

excerpts from Mauldin

[flow5]

By JON HILSENRATH WSJ
Federal Reserve officials last year, prodded by Chairman Ben Bernanke, seriously considered adopting an explicit target for inflation of 2%, but Mr. Bernanke failed to forge a consensus and backed away. The issue could resurface in 2011.

The Fed informally has said its goal is inflation of around 2%. But after years of internal debate on the subject, it hasn't adopted an official target.

Proponents say adopting a formal objective would blunt criticism of the Fed that current easy-money policies could lead to an upward spiral in consumer prices and could reinforce the Fed's commitment to avoiding deflation, or falling prices. Skeptics, however, wonder if an inflation target is needed and worry it could distract the Fed from its congressionally set mandate of maximum employment.

"An explicit inflation target would help us immensely," says Charles Plosser, president of the Federal Reserve Bank of Philadelphia and a longtime proponent. Mr. Plosser says he feels like Sisyphus, the mythical Greek condemned to pushing a boulder up a hill only to watch it roll down in his efforts to advance a target. "It helps promote the credibility of the central bank by being explicit about its objectives and it helps anchor [inflation] expectations," he says.

Proponents say inflation targets help to cement public expectations about price changes, making investment and spending decisions simpler. They also say targets help to give the public a roadmap for how the central bank is likely to behave—when inflation is running below target they would expect easy monetary policy and when above they would expect tight policy. It also provides more accountability than vague pledges of "price stability."

The European, British and Canadian central banks each set inflation targets—typically around 2%—and commit to move interest rates as needed to keep inflation near that goal.Meeting the goal isn't always easy. The Bank of England has a 2% goal and inflation there is now running over 3.5%, forcing it to write a public letter of explanation to the government.

Mr. Bernanke, a strong advocate of inflation targeting before he joined the Fed, has moved a reluctant Fed toward the approach. In January 2009, the Fed began publishing long-run inflation forecasts of its policy makers, essentially their long-term inflation goal. Forecasts cluster between 1.75% and 2%.

Inside the Fed, the idea resurfaced in the fall as the Fed debated the merits of initiating a $600 billion bond-buying program known as quantitative easing. In an Oct. 15 speech in Boston, Mr. Bernanke took another step, saying that Fed officials "generally judge the mandate-consistent inflation rate to be about 2% or a bit below." With inflation running at around 1%, he said there was a case for more Fed easing. An inflation target might be an easier sell when inflation is low; if it were adopted when rates were high, it would be seen as a reason for higher interest rates, which are never popular.

After the speech, Mr. Bernanke flew to Washington for a video conference call with other policy makers in which talk about targets quickly got bogged down on familiar issues, according to people who participated. One big hurdle was the Fed's legal mandate. The Federal Reserve Act requires the Fed to aim for "stable prices" and "maximum employment." Some officials worry that adopting an inflation objective could be viewed as putting more weight on inflation-fighting and less on unemployment-fighting.

Some argue an inflation objective might not be needed because the Fed's informal goal is well understood. "I think it's pretty clear that we have a relatively narrow range of inflation rates that we think about as mandate consistent," Narayana Kocherlakota, president of the Minneapolis Fed, said in a recent interview. Others at the October discussion worried that adopting an inflation goal while launching the new quantitative-easing program might confuse the public.

New challenges this year could put the inflation target back on the agenda. Several Republican lawmakers, concerned that the Fed is stoking inflation, have proposed narrowing the Fed's mandate to price stability, eliminating the employment part.

Adopting an inflation target would ease the concerns of legislators and the public about inflation, says Columbia University's Frederic Mishkin, a former Fed governor. "The Fed needs to make it clear that it will do whatever it takes to keep inflation from getting out of control," he says.

The controversial decision to embark on a new round of quantitative easing gave the Fed added reason to adopt a target, Mr. Mishkin says. "In order to make quantitative easing understandable you need to move in this direction of being much clearer about what your long-run inflation objective is and how quantitative easing fits into it," he says. Proponents also say an inflation target goes hand-in-hand with the Fed's employment objective because low inflation supports economic growth and hiring.

Those arguments don't fall on deaf ears at the Fed. Mr. Bernanke has been slowly building the case for setting an official inflation target since he joined the Fed in 2002. He has taken a number of steps toward implementing one and seems unlikely to give up the cause now.

=============

prices precede production

[bimetalaupt]

Jan 23, 2011 11:42:27 GMT -5 flow5 said:

The Unsustainable Meets the Irresistible

State and local spending is the second biggest component of the economy. The chart below, from David’s letter this week, gives us a visual image of just how large it is. Note that budget deficits at the state and local levels total more than 1% of GDP. Revenues, though, are still off 10% (on average) from where they were at the peak. The “fiscal stimulus” from the US government has run out and states and local communities are having to balance their budgets the old-fashioned way – through spending cuts and increased taxes.

As this budget cutting works its way through the economy, and as inventories are no longer being built (they are already at adequate levels), the growth from the current stimulus (both QE2 and payroll and federal government expenditures) the economy will have to stand on its own in terms of organic growth. And as the year wears on it will become apparent there is less true organic growth than currently meets the eye.

State and Local Spending
A few more thoughts on state and local spending. First, Congress needs to go ahead and authorize a bill allowing states to file for bankruptcy. At the very least, this sends a very clear message to the states that the federal government will not come to their aid. It is not fair to ask states that have done what they need to do to keep their fiscal houses in order, to support states that have overspent, typically by trying to fund their pensions and run other well-intentioned but underfunded programs.

Second, states need the ability to force public unions to come to the table. Many states have overpromised, and they are simply in a very deep hole and need concessions. Private workers have had to take the brunt of the recent crisis, and meanwhile government workers get far more on average than private employees.


You can see in the next graph that this differential has built up over time. It used to be that a federal government job paid less but was more secure. Now it is still more secure but pays about 44% more on average (35% higher wages and 69% higher benefits). (Source: Reason magazine)

Further, while there has been a clear drop in private employment, we have seen 10% growth in federal employment (state and local employment was flat through the middle of last year, but is likely to fall this year, with budget cuts).

That clearly implies there is room at the federal level for some “austerity.” The calls for a rollback to the budget and employment levels of 2007 will become more vocal as the set of facts we will address in a moment become evident.

Before we get to that, however, I want to take a side trip. Illinois recently passed a very real tax increase as a way to start the process of dealing with its massive deficits. It did so in a lame duck session of its state legislature, even though the voters had clearly elected a far more fiscally conservative legislature that would not have passed the tax increases.

The response of the governors of Indiana and Wisconsin, their closest neighbors? They immediately suggested to Illinois businesses that they are welcome to come to their states and set up shop and pay less taxes.

Higher taxes are hardly a cure. Look at the migration of businesses from high-tax states to low-tax states. Over the last ten years it has been pronounced. For those who argue that higher marginal taxes don’t make a difference, the facts clearly overrule you. Oregon decided to tax the wealthiest 2% of its citizens. They collected 40% less than they projected, and over 25% of the people they expected to tax somehow “disappeared.” And that is just in the first year. At some point, the “rich” get tired of being in the crosshairs of politicians and repair to more favorable climes.

This is all part of the national conversation we need to have on taxes and spending. That we need a complete tax overhaul, a thorough rethinking of how we raise the monies we need, should be obvious.

America, they assert, is in a fiscal trap due to the low interest rates we currently enjoy. What if I told you we could cut defense and discretionary spending by 20%, put in a two-year pay freeze on federal employees, and go ahead and let the Bush tax cuts on the “rich” expire. Wouldn’t that go a long way to fixing the deficit? The answer is, sadly, likely to be no.

As the table shows, if interest rates go back to their long-term historical average, spending could rise by $800 billion in just 8 years. Even under the more optimistic assumptions of the Congressional Budget Office, it is still $500+ billion. The government debt held by the public would be around 120% of GDP (back of my napkin), or close to what I said last week was completely unsustainable by the Irish. It will be no less so for the US. Spend a few moments with the table, and see how even deep cuts and freezes have so little impact. That is not to say they are not necessary, but this just shows that a much different approach is needed.


seekingalpha.com/article/247988-u-s-fiscal-situation-the-unsustainable-meets-the-irresistible?source=email_partial_daily_dispatch

excerpts from Mauldin

Flow5,
I thought the 10 year average M3 and M2 was interesting .. Last year M3 declined 1.2% and M2 was up 3.6%.. We may have solved the inflation question for the time but at what cost.. The great recession esp in Home prices... There is a true correlation esp M3 and inflation!!! the 10 year MA is also interesting... you can clearly see the one year lag.. Thoughts???

Just a thought,
Bruce

Attachments:

[flow5]

There's a significant distinction between liquid assets & money. However, it's not surprising to find a loose correlation between M3, production, & prices. Liquid assets comprise the largest share of M3. As such, the growth of M3 signifies the turnover of existing money or fundamentally depicts just the velocity of previous investment.

Money flows measures aggregate monetary purchasing power (our means-of-payment money X's its transactions rate of turnover). I.e., Mvt is a product of two variables, & represents money (real-time), actually exchanging hands.

Mvt is also equal to nominal gDp. Therefore the rate-of-change in Mvt will approximate the rate-of-change in nominal gDp for the same time period. And the expected growth rate of nominal gDp is fundamental to any investment plans.

I don't give m3 that much thought, except to think that M3 also represents changes in the Shadow Banking system, or the size of the true financial intermediaires (intermediaries between saver & borrower). I.e., formally 82% of all lending was performed by the non-bank financial institutions.

In a healthy economy, Reserve & Commercial bank financing is restricted to minimal volumes.

I hope that gives M3 some perspective.

[flow5]

"Major Swap Participants" — Taking Apart the CFTC's Proposed Rule Posted by Economics of Contempt at 1:50 PM
One of the most important issues in the derivatives title of Dodd-Frank is who qualifies as a “major swap participant” (MSP). These are supposed to be entities that aren’t swap dealers, but are still big enough players in the swap markets that their failure could cause serious problems. In other words, the major buy-side players (AIG, Blackrock, etc.). The reason this is so important is that MSPs are subject to much more stringent regulation by the CFTC, including — significantly — capital and margin requirements.

The CFTC has now published a proposed rule (pdf) defining “major swap participant,” and it’s safe to say that I’m not a fan. It’s a mess: not well drafted, and way too easy to evade (i.e., underinclusive). Or, I should say, it’s probably too easy to evade — it’s not entirely clear, due to the serious drafting issues. I know this isn’t a very sexy issue, but this is the important stuff, so bear with me.

Dodd-Frank creates three tests for determining whether an entity qualifies as a MSP, though only the first two are important for our purposes. The first test states that a MSP is anyone who isn’t a swap dealer and who:


(i) “maintains a substantial position in swaps for any of the major swap categories,” excluding “positions held for hedging or mitigating commercial risk” and certain employee benefit plans.
The second test states that a MSP is anyone who isn’t a swap dealer and:

(ii) “whose outstanding swaps create substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets.”
1. “Substantial Position” Test

The CFTC’s first task, which I think they did reasonably well, was to determine what constitutes a “substantial position in swaps for any of the major swap categories.” To do this, they created two “substantial position” thresholds. The first threshold is based on an entity’s current uncollateralized exposure, and the CFTC’s proposed rule sets the threshold at a daily average of $1bn for credit, equity, or commodity swaps, and $3bn for rate swaps. The second, broader, threshold is based on an entity’s potential future exposure, and is set at a daily average of $2bn for credit, equity, or commodity swaps, and $6bn for rate swaps.

This part is largely fine. Current uncollateralized exposure is, intuitively, a good measure of the risk that an entity poses to the broader market, and creating a second, broader threshold as a fail-safe is probably a prudent move. I would, however, object to the CFTC’s decision to rely on “industry practices” for the valuation of posted collateral. Those standards aren’t exactly rigorous, even now, and would be ripe for abuse.

Where the wheels really start to come off the wagon is in the CFTC’s definition of “positions held for hedging or mitigating commercial risk” — which, remember, are excluded from the “substantial position” calculations. Ideally, this term should be defined as narrowly as possible, because current uncollateralized exposure is already a good measure for whether an entity poses a systemic risk.

Unfortunately, the CFTC defines this term by first creating a cartoonishly broad list of transactions that are included in the definition, and then creating an almost-as-broad (but horribly drafted) list of transactions that are excluded from the definition of “hedging or mitigating commercial risk.” For example, the list of transactions that qualify as “hedging or mitigating commercial risk” includes any transaction that is “economically appropriate to the reduction of risks” arising from:

(A) The potential change in the value of assets that a person owns ... or reasonably anticipates owning ... in the ordinary course of business of the enterprise;

(B) The potential change in the value of liabilities that a person has incurred or reasonably anticipates incurring in the ordinary course of business of the enterprise;
...
(F) Any fluctuation in interest, currency, or foreign exchange rate exposures arising from a person’s current or anticipated assets or liabilities.
That describes virtually every single swap that has ever been written — and that’s only part of the list! Then comes the list of transactions that are excluded from the definition of “hedging or mitigating commercial risk,” which is defined as transactions that are:

(i) Not held for a purpose that is in the nature of speculation, investing or trading; [AND or OR? It doesn't say]

(ii) Not held to hedge or mitigate the risk of another swap or securities-based swap position, unless that other position itself is held for the purpose of hedging or mitigating commercial risk.
Gee, it’s a good thing that “held for a purpose that is in the nature of speculation, investing or trading” isn’t broad or ambiguous at all... But seriously, while this phrase is clearly intended to be broad, in order to counteract the cartoonishly broad list of included transactions, I think it’s highly likely that, due to the way it’s drafted, it will only end up encompassing a relatively narrow band of trades that are obviously speculative. Any swaps that an entity can claim are being held for the “purpose” of hedging non-swaps — which would pretty clearly distinguish them from swaps held for the “purpose” trading — will likely fall outside this definition.

Since swaps are frequently used to hedge fixed-income instruments, as opposed to hedging other swaps, the end result is that a large class of swaps will be able to claim the “hedging or mitigating commercial risk” exemption — and will thus be excluded from the “substantial position” calculation.

In short, the CFTC’s “substantial position” test creates enormous ambiguities, and will likely be relatively easy to evade.

2. “Substantial Counterparty Exposure” Test

The “substantial counterparty exposure” test is supposed to make up for this, by calculating current uncollateralized exposure and potential future exposure without any exclusion for “hedging or mitigating commercial risk.” (Or, at least, that’s how the CFTC explains it in the Federal Register.) The first problem is that, based on the language of the proposed rule, it doesn’t do what it’s intended to do. The rule states:

(2) Calculation methodology. For these purposes, the terms “daily average aggregate uncollateralized outward exposure” and “daily average aggregate potential outward exposure” have the same meaning as in § 1.3(sss) [the “substantial position” test], except that these amounts shall be calculated by reference to all of the person’s swap positions, rather than by reference to a specific major swap category.
Well, if the terms have the same meaning as they do in § 1.3(sss), which is the provision establishing the “substantial position” test, then they do still include the exemption for hedging/mitigating commercial risk. Section 1.3(sss) states that “the term ‘substantial position’ means swap positions, other than positions that are excluded from consideration, that equal or exceed [the two] thresholds.” The rule needs to explicitly state that it doesn’t include the exemption for hedging/mitigating commercial risk. As it stands right now, the hedging/mitigating commercial risk exemption is still included the “substantial counterparty exposure” test — making it just as useless as the “substantial position” test.

The second problem is that the “substantial counterparty exposure” test raises the thresholds for current uncollateralized exposure and potential future exposure to $5bn and $8bn, respectively. That strikes me as clearly too high. I mean, $5bn in current uncollateralized exposure isn’t exactly chump change, especially when you consider that we’re only talking about an entity’s swap book. Any entity that has $5bn in current uncollateralized exposure just in its swap is likely going to have significant uncollateralized exposure in other products too. I realize that the statute only refers to swaps, but the CFTC can get around this by simply adjusting the threshold down.


***

Incidentally, the SEC published a nearly identical proposed rule for “major security-based swap participants.” However, the SEC’s rule appears to be much cleaner and tighter than the CFTC’s rule.

I certainly understand that the CFTC has an absurd amount on their plate right now, and still doesn’t have adequate funding, so I think drafting issues like the ones in this proposed rule are entirely understandable. But hey, someone has to pick the proposed rules apart, and it might as well be me.

economicsofcontempt.blogspot.com/2011/01/major-swap-participants-taking-apart.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+economicsofcontempt+%28Economics+of+Contempt%29

[flow5]

The SAGA continues:

Today's Edition Of The FRBNY's "Flip That Bond" Criminal Reality Show Is Now In The Books, As Primary Dealers Continue To Churn Just Issued Bonds
Submitted by Tyler Durden on 01/24/2011 11:50 -0500

POMOReality


The Fed's blatant "Flip That Bond" criminal reality show, funded entirely by you, dear taxpayer, continues, and is in fact accelerating. Over the weekend we provided a list of the 10 cheapest bonds that the Fed should monetize based on their relative position on the spline, in terms of cheapness/richness (link) and implied that should the Fed veer away from this list, it would be engaging in what is certainly non-fiduciary activity, by merely facilitating taxpayer rape on behalf of the Primary Dealers who "put" to Sack Frost whatever issue they want, and certainly not the cheapest ones to be monetized by the US taxpayers (i.e., an act that would at least pretend to save some money). Specifically, we said: "The just auctioned off 2.75% of 12/31/2017 is not even among the top 10 cheapest bonds, which means that if on Monday the PN4 makes up for a material percentage of the $7-9 billion buyback, then something is very, very wrong."

Well, one look at the final completion list of Today's POMO indicates that it is precisely the just auctioned off PN4 due 12/31/2017 that made up over half of the entire bloody operation! At 4.551 billion (out of a total $8.869 billion in bonds monetized), the Fed actively conspired with PDs to defraud taxpayers by engaging in monetization not of bonds that were cheapest and thus bonds the Fed should have been buying, but merely was taking the other side of the trade in today's version of "Flip That Bond." And so the criminality continues unabated.

In Exhibit A for the criminal behavior by the Fed's OMO desk, the bonds that should have been bought are highlighted in Green. Instead, the flip bond, that was monetized the most, and completely in contradiction to market price dynamics such as supply and demand, is the one highlighted in red.



Oh, and with the S/A ratio well below the average, expect the Dow to close somewhere around 12,000 today as the gang rape of the middle class continues.

[flow5]

Interesting tidbit on M2:

"There is a strong correlation between big increases/decreases in refinancing activity and faster/slower growth of M2. That's because the refinancing process temporarily creates a lot of extra "money" as money flows into and sits in escrow accounts. Most recently, M2 growth has slowed sharply (the result of rising interest rates since last summer), just as refinancing activity has dropped rather rapidly. The recent slow growth in M2 (2.5% annualized growth over the past three months) is nothing to worry about, because it is most likely the natural result of a decline in mortgage refi activity"


Calafia Beach Pundit
==============

Interesting tidbit on refi's & M2. Escrow accounts classified as belonging to the M2 aggregate. Mortgage suppliers were originally dominated by the S&L's, & Mutual Savings banks. Those intermediaries were the customers of the commercial banks and held large balances in the CBs (some of those balances were previously classified in the M1 aggregate, but MSB's balances in the CB's were designated as IBDD's).

[bimetalaupt]

Jan 24, 2011 13:48:18 GMT -5 flow5 said:

Interesting tidbit on M2:

"There is a strong correlation between big increases/decreases in refinancing activity and faster/slower growth of M2. That's because the refinancing process temporarily creates a lot of extra "money" as money flows into and sits in escrow accounts. Most recently, M2 growth has slowed sharply (the result of rising interest rates since last summer), just as refinancing activity has dropped rather rapidly. The recent slow growth in M2 (2.5% annualized growth over the past three months) is nothing to worry about, because it is most likely the natural result of a decline in mortgage refi activity"


Calafia Beach Pundit
==============

Interesting tidbit on refi's & M2. Escrow accounts classified as belonging to the M2 aggregate. Mortgage suppliers were originally dominated by the S&L's, & Mutual Savings banks. Those intermediaries were the customers of the commercial banks and held large balances in the CBs (some of those balances were previously classified in the M1 aggregate, but MSB's balances in the CB's were designated as IBDD's).

Flow5,
I am not sure where they got 2.5% increase in M2.. What was the date of the article. H.6 is showing 3.4% (Dec 2010 over Dec 2009)
Bruce
--------------------------------------------------------------------------------------------------------------------------------------------------------
Percent change at seasonally adjusted annual rates M1 M2
--------------------------------------------------------------------------------------------------------------------------------------------------------
Thirteen weeks ending January 10, 2011
from thirteen weeks ending:
Oct. 11, 2010 (13 weeks previous) 12.9 5.3
July 12, 2010 (26 weeks previous) 11.8 5.1
Jan. 11, 2010 (52 weeks previous) 7.8 3.4
--------------------------------------------------------------------------------------------------------------------------------------------------------
Note: Special caution should be taken in interpreting week-to-week changes in money supply data, which are highly volatile and subject to revision.

p preliminary
Components may not add to totals due to rounding.
1

[bimetalaupt]

Let me get the correct chart.. Both 52 weeks and 12 months show 3.4% increase 2010 over 2009..
----------------------------------------------------------------------------------------------------------------------------------------------------
Percent change at seasonally adjusted annual rates M1 M2
----------------------------------------------------------------------------------------------------------------------------------------------------
3 Months from Sep. 2010 TO Dec. 2010 13.0 5.0
6 Months from June 2010 TO Dec. 2010 12.1 5.1
12 Months from Dec. 2009 TO Dec. 2010 8.2 3.4
----------------------------------------------------------------------------------------------------------------------------------------------------
1. M1 consists of (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler's checks of
nonbank issuers; (3) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. government, and
foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; and (4) other checkable deposits
(OCDs), consisting of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institutions, credit union
share draft accounts, and demand deposits at thrift institutions. Seasonally adjusted M1 is constructed by summing currency, traveler's checks,
demand deposits, and OCDs, each seasonally adjusted separately.
2. M2 consists of M1 plus (1) savings deposits (including money market deposit accounts); (2) small-denomination time deposits (time deposits in
amounts of less than $100,000), less individual retirement account (IRA) and Keogh balances at depository institutions; and (3) balances in
retail money market mutual funds, less IRA and Keogh balances at money market mutual funds. Seasonally adjusted M2 is constructed by summing
savings deposits, small-denomination time deposits, and retail money funds, each seasonally adjusted separately, and adding this result to
seasonally adjusted M1.

p preliminary
Components may not add to totals due to rounding.

[flow5]

Good question. The numbers don't jive. Jan 23.

"The evidence of monetary excess is elusive, but it can be found"

scottgrannis.blogspot.com/

[flow5]

Econbrowser

February 23, 2010
Treasury Supplementary Financing Program (SFP)The SFP, the U.S. Treasury's program for assisting with the balance sheet of the Federal Reserve, is making a sudden and dramatic comeback.

First a little background. Whenever the Federal Reserve buys an asset or makes a loan, it simply credits new reserve deposits to the account that the receiving bank maintains with the Fed. The bank would then be entitled to convert those deposits into physical dollar bills that it could ask the Fed to deliver in armored trucks. Banks currently hold $1.2 trillion in such reserves, or more than a hundred times the average level of these balances in 2006, and more than the total cash the Fed has delivered since its inception a century ago. The traditional way the Fed would bring those reserves back in (and thus prevent them from ending up as circulating cash) would be to sell off some of its assets.

The Treasury's Supplementary Financing Program was introduced in the fall of 2008 to assist the Fed in its massive operations to prop up the financial system at the time. The SFP represents an alternative device by which the Fed could reabsorb the reserves it created. Essentially the Treasury borrows on behalf of the Federal Reserve, and simply holds the funds in the Treasury's account with the Fed. When a bank delivers funds to the Treasury for purchase of a T-bill sold through the SFP, those reserve deposits move from the bank's account with the Fed to the Treasury's account with the Fed, where they now simply sit idle, and aren't going to be withdrawn as cash. In a traditional open market sale, the Fed would sell a T-bill out of its own portfolio, whereas with the SFP, the Fed is asking the Treasury to create a new T-bill expressly for the purpose. But in either case, the sale of the T-bill by the Fed or by the Treasury through the SFP results in reabsorbing previously created reserve deposits.

The Treasury's press release says only this:

Treasury anticipates that the balance in the Treasury's Supplementary Financing Account will increase from its current level of $5 billion to $200 billion. This will restore the SFP back to the level maintained between February and September 2009.

This action will be completed over the next two months in the form of eight $25 billion, 56-day SFP bills. Starting tomorrow, SFP auctions will be held each Wednesday at 11:30 a.m. EST, unless otherwise noted.

So this is going to be implemented immediately and on a large scale. But why? If the goal were indeed to drain reserves, the Fed could do this by selling some T-bills out of its own holdings, currently some 3/4 trillion, or could do this with reverse repos or the Term Deposit Facility, not to mention selling some of its trillion dollars worth of MBS. And just two weeks ago Fed Chair Ben Bernanke seemed to be saying that such steps were still far in the future, and did not even mention the possibility of a surge in the SFP.

You want more information? We've got this:

"We're committed to working with the Federal Reserve to ensure they have the flexibility to manage their balance sheet," a Treasury official said on background.

Anonymous and on background in order to say nothing at all? What's the big secret?

An alternative hypothesis is that the Fed intends not to retire reserves but instead to expand its balance sheet without increasing reserves, that is, use the funds to make new asset purchases or loans with the SFP sterilizing the operations. But what loan is the Fed about to make or asset is it about to purchase? WSJ Real Time speculates:

The practical effect of this move is that the Fed will be able to finish $1.25 trillion of purchases of mortgage backed securities by the end of March without printing more money. Instead, it will have the cash on hand from the Treasury deposits to fund the purchases. As of February 17, the Fed's portfolio of mortgage backed securities had reached $1.025 trillion, roughly $200 billion short of the objective.

But I'm puzzled with how that reconciles with this statement from the Federal Reserve Bank of Atlanta on February 10 (hat tip: Calculated Risk):

The Fed purchased a net total of $12 billion of agency-backed MBS through the week of February 3, bringing its total purchases up to $1.177 trillion, and by the end of the first quarter 2010 the Fed will have purchased $1.25 trillion (thus, it is 94% complete).... the Fed needs to purchase only about $9.2 billion per week through March 2010 to reach its goal.

The discrepancy seems to arise from the fact that the Fed's February 18 H41 release listed its MBS holdings on Feb 17 as $1,025 billion, or $152 billion less than the $1,177 billion that the Federal Reserve Bank of Atlanta claimed the Fed had purchased as of Feb 3. The Atlanta numbers seem to be the accumulation of weekly net MBS purchases (that is, gross purchases minus gross sales) reported by the Federal Reserve Bank of New York. Perhaps it takes a while between the time the NY Fed executes the purchases and the time they are settled and show up on the Fed's H41 balance sheet, or perhaps there is some separate device for accounting for maturation and prepayment on the MBS. If the latter, then at a minimum the WSJ and FRB Atlanta had a different understanding of how far the Fed intended to go with its MBS program. And under either interpretation, if the $200 billion in new funding is just for something that was already etched in stone weeks ago, the sudden announcement that it is going to be implemented with an immediate resurrection of the SFP seems all the more mysterious.

WSJ Real Time offers this perspective from Lou Crandall:

The intention always was to resume SFP issuance when the debt ceiling was increased on a permanent basis, which finally happened earlier this month.

So maybe this has been in the cards for a while, with the apparent suddenness and clunkiness from the perspective of an outsider like me having an explanation in the fact that the political negotations behind such a move may in fact force a certain suddenness and clunkiness on steps that the Federal Reserve on its own might wish to see implemented with more transparency and predictability.

Still, one is led to wonder whether there might be a connection between today's announcement about the SFP and last week's announcement of an increase in the Fed's discount rate. Numerous Fed officials encouraged us to interpret the latter as a routine and technical management tool. Are the discount hike and SFP renewal separate and purely technical developments, or is something more involved?

Perhaps Bernanke's remarks tomorrow will give us more to go on.

[flow5]

WASHINGTON (MarketWatch) -- The Treasury Department announced Tuesday that it is expanding its Supplementary Financing Program to help the Federal Reserve manage its enormous balance sheet. In a statement, Treasury said it will boost the SFA to $200 billion from its current level of $5 billion. The fund had been up to $200 billion but was scaled back when Congress delayed passage of an increase in the debt limit. Now that an expansion of the debt limit has been signed into law, the department is able to resume the program. Starting on Wednesday, Treasury will conduct the first of eight weekly $25 billion 56-day SFP bills to restore the program. The department said it will then roll the bills over. "We are committed to work with the Fed to ensure they have the flexibility to manage their balance sheet," a Treasury official said.

[bimetalaupt]

FLOW5, GREAT POST.. YOU ARE 100% UP TO YOUR BEST GAME...
YES.. BUT YOU KNOW BEN B.WILL MAKE A LOT MORE MONEY FOR THE TREASURY!!!


Just a thought,
Bruce

[flow5]

Here Comes Another $25 Billion In Excess Weekly Liquidity To Ramp Up Stocks
Submitted by Tyler Durden on 01/24/2011 15:56 -0500

Cash Management BillsDebt CeilingPOMOQuantitative Easing


Frequent readers may recall that 11 months ago, when the economy was falsely rumored to be doing better, and the Fed was expected to take baby steps in withdrawing liquidity (only to end up having to inject another $900 billion shortly... and probably much more soon), one of the key mechanisms used was the Treasury's Supplementary Financing Program, whereby the Treasury would issue 56-Day Cash Management Bills each week with a $200 billion ceiling. In addition to funding the Treasury with a $200 billion debt ceiling buffer, the program was supposed to extract a fifth of a trillion in liquidity which would be locked into the rolling of each 56 day bill (each one amounting to $25 billion) up to a total of $200 billion, as disclosed each day in the Treasury's DTS SFP Table 1 open cash balance. Well, not even 11 full months later, it is now time to unwind the program. The immediate catalyst for the unwind of the SFP is that the Treasury will most certainly breach the debt ceiling by the end of March unless it gets the benefit of the $200 billion buffer, which counts toward the total debt issued by the UST. However, what that also means is that the US stock market is about to become awash with another $25 billion in suddenly free cash every single week, until the entire $200 billion SFP buffer is depleted. In other words, take the liquidity impact of POMO, which is roughly $25-30 billion a week, and double it! We are confident the US Treasury will announce that beginning with the week of February 14, it will no longer roll maturing 56-Day Cash Management Bills, which means that for the ensuing 8 weeks, one on every single Thursday, there will be a total of $200 billion in incremental liquidity flooding the market, and probably sending stocks, commodities, and everything else that is not nailed down into the stratosphere all over again.

Below is a table laying out our estimated weekly liquidity boost. We believe the starting date for the SFP winddown will be the week of February 14, although we could be off by one week in either direction.



This makes sense, especially when considering of our expectation that the Fed will force the market to do a repeat performance of 2010, whereby it goes parabolic through mid-April and then it is smashed in another flash crash like event due to some exogenous variable, opening up the path for further Quantitative Easing. That said, it is likely that the PDs and the Fed's OMO will now orchestrate the perfect market boil up over the next 2 months as more than ample liquidity chases stocks at increasingly ridiculous multiples until the point where everything goes bidless just like on May 6

[flow5]

Fed Speak & the WSJ - Bruce Krasting
It doesn’t seem so long ago that every Thursday at 4 pm I would be strapped in seat hoping for the best and fearing for the worst. Thursday afternoon was when the money supply numbers used to come out. The numbers moved prices, big. Think of how the market reacts to monthly Non-Farm Payroll number today. Days both pre and post 1st Friday it influences talk and markets. It was the same back then with the Ms.

In many ways if was even worse than the NFPs. The Ms came out 4 times a months instead of just one. And the tape crossed on this exactly at 4pm. There is no market to move size after 4. You had to something in Asia or Europe. Often you had to wait to the following morning in NY to find liquidity.

People made/lost fortunes on this. An outfit called Salomon Brothers had a guy named Henry Kaufman. He was good with numbers, and had a real handle on calling the headline. “Henry the K” would whisper in someone's ear and the Brothers made a bundle playing both sides of the casino.

It got so out of hand that they changed the rules. They moved the numbers to a Friday 4pm release. This of course was the worst possible choice for guys like me. You had to wait the whole weekend to see how things would work out. I lost a few weekends worrying about Monday.


Here’s the joke. These numbers mean next to nothing today. They actually stopped keeping track of M3. Money supply is still discussed, but the weekly numbers are a ho-mummer. Think of what a stupid fixation the market had at that time. We might do it again.

I bring this up because I do not believe in coincidences. Here is an example of a “coincidence” that should not be trusted. The first piece is that the Fed is releasing a statement at 2:15 Wednesday. The second is that Jon Hilsenrath wrote (another) article that give a very clear insight into the thinking of Mr. Bernanke.

The bottom line on the Hilsenrath story is that Bernanke is pushing to change monetary policy so that it goes on autopilot when inflation exceeds or falls below clearly defined bands.

Bernanke is an academic. He wants a computer to define when to tighten and when to loosen policy. That view fits in with his orderly view of the world. Oh, that it were orderly.

Ben also wants to introduce this new policy as a defensive move. He knows he is headed for a ton of criticism over QE. Both domestically and internationally. To blunt that he will introduce Inflation Targeting (“IT”). It removes him as a decision maker, so no one can blame him for the consequences. Very convenient. Not unlike the new rules that make it impossible for the Fed to incur a loss.

The Fed statement should be, well, a ho-hummer. No changes to anything. But read through the language and I think you will find:


i) Some talk that the Fed is forming a formal group to review inflation targeting as a policy determiner.


ii) A meaningful increase in the GDP forecast for 2011. If they push this estimate to 3.3% or higher it will fly in the face of continuing QE.


If you play poker you look for “tells”. Something that gives you a better “read” on the other guy’s hand. Should we see some language from the FOMC that confirms they are going forward with IT there will be two tells. The first is that it confirms the cozy link between Bernanke and the WSJ. It will also confirm that Bernanke is calling all of the shots. Everyone else is just saying “yes”. (Look for no dissenters Wednesday. New Board = Yes Ben)

US monetary policy can’t be run by a robot. A pragmatic approach is required. Bernanke is shunning the Fed’s responsibilities. He doesn’t want the Fed to be accountable. Very convenient.

IT won’t work of course. It will drive the market nuts with every blip up and down with every measure of inflation out there. Because the Fed has set visible targets they will be forced to act. Failure to do so would be very damaging to their credibility. But they will inevitably be forced to act at precisely the wrong time and in the wrong fashion. Just like they have done in the past.

The funny thing? 20 years from now someone will write about this and point to the new street bandits that made a killing and conclude, “what a stupid fixation the market had”.

[flow5]

Did you see this on M2?

Another example from Rebecca Wilder:

"These days it's all about credit. I'm sitting in Cosi right now - bought a sandwich and charged the bill on my credit card. Actually, I prefer to use cards. But M2 doesn't account for this transaction as money if the balance is never paid in full. M2 is essentially currency, checking deposits, saving and small-denomination time deposits, and readily available retail money-market funds (see Federal Reserve release).

One can argue about the merits of including credit cards balances as "money", per se. However, the sharp reversal of revolving consumer credit, and likely through default (see the still growing chargeoff rates for credit card loans), would never be captured in M2.

The hangover from the last decade of households using their homes as ATM's (i.e., home equity withdrawal) and running up credit card balances to serve as a medium of exchange is dragging nominal income growth via a sharp drop in aggregate demand."

[bimetalaupt]

Jan 25, 2011 10:50:48 GMT -5 flow5 said:

Did you see this on M2?

Another example from Rebecca Wilder:

"These days it's all about credit. I'm sitting in Cosi right now - bought a sandwich and charged the bill on my credit card. Actually, I prefer to use cards. But M2 doesn't account for this transaction as money if the balance is never paid in full. M2 is essentially currency, checking deposits, saving and small-denomination time deposits, and readily available retail money-market funds (see Federal Reserve release).

One can argue about the merits of including credit cards balances as "money", per se. However, the sharp reversal of revolving consumer credit, and likely through default (see the still growing chargeoff rates for credit card loans), would never be captured in M2.

The hangover from the last decade of households using their homes as ATM's (i.e., home equity withdrawal) and running up credit card balances to serve as a medium of exchange is dragging nominal income growth via a sharp drop in aggregate demand."

fLOW5,
MMXI USES NONE M1-M2 BECAUSE OF THE SUPERIOR CORRELATION'S TO EVENT DRIVEN MARKET ACTION THEN M1 . I AM NOT SURE ABOUT BEN B. ACTION BUT IT LOOKS LIKE HE HAD A REAL EFFECT ON GERMANY.. STEP UP OR MOVE OUT OF THE WAY.. ANY WAY YOU LOOK AT IT , IT IS ABOUT MONEY AND HOW TO USE IT FOR THE BENEFIT OF THE BANKS OWNERS (BANKS)... WE HAVE A LOT OF THINGS TO LOOK AT..like not very solvent Spanish Banking system!!!
BTW M2 is a bit less meaningful on correlations then None M1-M2 but not as much as the M1 gap. ( real Numbers from MMXI V2 Gold 2011.. five minutes ago run!!!(jan 25,2011 11:09 EST)

Just a thought,
Bruce
Picture... Paul Moritz Warburg He was very much all about banking and stronger then Max the brother he left in Germany to serve as the German's Government Banker!!

Attachments:

[flow5]

The debit and demand deposit turnover (G.6 series), showed debits to demand deposits (& after the DIDMCA, debits to a variety of other accounts). The difference between the various classifications of deposits was striking. It's undoubtably changed by now though. But, based upon the lopsided number of transactions hitting against demand deposits, I can't see the benefit of using other money aggregates as a short-term key.

[flow5]

The rate-of-change in money flows is always measured with the same length of time as the specific economic lag (as its influence approaches its maximum impact (not date range); as demonstrated by the clustering on a scatter plot diagram). These lags have been set at closed intervals for the last 97 years.

So, I would expect (given forecast errors), that money flows will always "revert to mean". Obviously, that's why the proxy for inflation (long-term money flows), is falling in tandem with housing & core CPI.

I also had the caveat that (for legal reserves), the calculations should reflect "as the weighted arithmetic average of reserve ratios remains constant". The Board of Governors has made 2 significant revisions, yet has not posted any kind of notice, nor provided an explanation of the changes.

That's how the FED has always covered its tracks.

[flow5]

The Treasury Department will probably reduce its borrowing on behalf of the Federal Reserve as the Obama administration and Congress battle over raising the U.S. debt limit, according to Wrightson ICAP LLC.

Treasury officials may shrink the Supplementary Financing Program, currently at $200 billion, to as little as $5 billion while the government’s debt approaches its $14.29 trillion threshold, said Lou Crandall, chief economist at Wrightson, a Jersey City, New Jersey-based research firm that specializes in U.S. government finance. Treasury Secretary Timothy F. Geithner said Jan. 6 that lawmakers must raise the federal borrowing ceiling in the first quarter or risk a default on U.S. debt and a loss of access to credit markets.

When the Treasury sells bills at the Fed’s behest through the SFP, it drains reserves from the banking system and makes the central bank’s job of controlling interest rates easier. The Fed said a year ago that the program, set up in 2008 during the midst of its efforts to prop up the financial system, is helpful to the central bank’s monetary policy goals and might be part of future efforts to withdraw economic stimulus. Treasury estimates the legal limit could be reached between March 31 and May 16.

“Time is running out on the SFP auctions, but there is little risk that the Treasury will terminate them without any advance warning,” Crandall said in a telephone interview. “If the debt ceiling drags on to the point where the Treasury must take more drastic steps to stay under the limit, it might eliminate the SFP altogether.”

Borrowing Strategy

The Treasury will provide a borrowing strategy update on Feb. 2, when it announces the amount of securities it will sell under what’s become known as its quarterly refunding. The SFP program is not listed as a topic on the official agenda for the Jan. 28 meeting of the Fed’s 18 primary dealers that takes place before the release of the policy statement.

Colleen Murray, a Treasury spokeswoman in Washington, declined to comment on plans for the SFP. In a Jan. 21 comment on the Treasury’s website, Deputy Secretary Neal Wolin called on Congress to raise the limit and said proposals to “prioritize” debt payments over other obligations would be “unworkable.”

Focus on the debt ceiling, which was increased a year ago, has risen since Republicans won control of the House of Representatives in November with pledges to challenge the Obama administration on spending. GOP lawmakers have told President Barack Obama and Democratic legislators that they will insist on specific cuts as a condition of raising the U.S. debt limit.

Emergency Measures

The U.S. can’t avoid reaching the debt limit by reducing the budget as being proposed by some lawmakers, Geithner said. “The need to increase the debt limit would be delayed by no more than two weeks,” Geithner said in his Jan. 6 letter to Speaker of the House John Boehner, Senate Majority Leader Harry Reid and all other members of Congress.

The Treasury chief also said his department’s toolkit of emergency measures, such as tapping government retirement funds and suspending some types of intergovernmental lending, would delay a debt ceiling breach “by several weeks.” At that point, he said, “no remaining legal and prudent measures” would be available and the U.S. would start to default.

Treasury would likely shrink the SFP before the limit is reached, according to Barclays Plc and Deutsche Bank AG. The Treasury has shrunk the SFP in two previous debt-limit standoffs and then brought it back when Congress restored borrowing room.

General Collateral

Removing most of the SFP program’s $200 billion in bills from the market would trigger three-month rates to fall by over 0.10 percentage points, according to Deutsche Bank. Overnight repurchase agreement rates, which firms use to finance debt holdings, may slide more, according to Barclays, which along with Deutsche Bank is one of the primary dealers that trade with the Fed.

The overnight general collateral repurchase agreement rate was 0.23 percent, compared with the Fed’s target rate for overnight loans of zero to 0.25 percent. Government securities that can be borrowed in the repo market at rates close to the Fed’s target are called general collateral.

Ending the SFP program could cause the rate on the three- month Treasury bill to slide to as low as 0.01 percent from 0.15 percent, Marcus Huie, fixed-income strategist at Deutsche Bank in New York, said in a telephone interview.

“The cut in bill supply will cause the entire short-end of the yield curve from bills out to the two-year Treasury note to richen, with rates falling,” Huie said. Two-year notes yield 0.62 percent.

As the Treasury cuts SFP bills, it also will have a seasonal need to increase its other bill offerings, Joseph Abate, money-market strategist at Barclays in New York, said in an interview. The net effect would cause overnight repo rates to fall to around 0.15 percentage points or less by the second quarter, Abate said.

[scaredshirtless]

So...

In regards to the SFP program revelations and associated additional pumping...

Stocks to the moon now?

[flow5]

The FED has 2 formally, legislated, mandates & one informal one. I.e., with our enormous federal deficit, the FED has no choice but to support the Treasury market. When it purchases government securities from the member banks (the primary dealer market), these sophisticated traders (given more profitable opportunities), have heretofore swapped their assets holdings (& altered their investment portfolio preferences) with higher equity allocations. Whatever gives them a higher return on their money will be their focus.

[flow5]

NEW YORK, Jan 25 (Reuters) - In a big victory for banks, U.S. accounting rule-makers moved on Tuesday to reverse a controversial plan that would have forced banks to value many of their loans based on market movements.

The step by the Financial Accounting Standards Board to scale back a "fair value" accounting proposal was applauded by the banking industry, which has lobbied fiercely against it amid concerns that it would curb lending and hurt an already fragile economy. FASB sets U.S. accounting standards.

Under the accounting model tentatively approved by FASB on Tuesday, banks like Bank of America Corp(BAC.N) and JPMorgan Chase & Co (JPM.N) will be able to continue valuing some of their loans at adjusted historical costs instead of being forced to adjust the loans' value based on market movements.

"Today's shift recognizes investor concerns that a company's business model should be a key factor in measuring financial instruments," said Frank Keating, president and chief executive officer of the American Bankers Association.

"While mark-to-market can be very useful for a business that trades financial instruments, the most appropriate accounting measure for a loan portfolio is the loan balance minus impairment," he said.

The ABA said the tentative decision is expected to result in a final standard later this year.

A tightening of fair value or mark-to-market accounting has often been blamed by critics, including members of Congress, for intensifying the financial crisis. Those critics say the accounting practice triggered massive bank write-downs as prices of mortgage securities fell.

FASB's decision came after numerous investors weighed in to say they favored amortized cost accounting for assets that are held on a company's books, FASB Chairman Leslie Seidman told reporters during a webcast briefing.

The decision on valuing loans is part of a wide-ranging change in rules governing how companies account for financial instruments, expected to be completed by June.

Financial instrument accounting is one of several high-priority projects FASB is working on as it tries to align U.S. accounting standards with international rules.

Seidman said FASB is still very committed to reaching a single, consistent set of global standards and is working to complete its top-priority projects by midyear.

In addition to financial instruments, FASB is also targeting a June completion date for rules on revenue recognition, leases and presentation of other comprehensive income.

Seidman said FASB also plans to reconsider many parts of its proposal on lease accounting, another standard that drew staunch opposition from business groups.

The proposal would require companies to bring hundreds of billions of dollars of leases onto their balance sheets, a move meant to give a truer picture of companies' liabilities.

Retailers and other businesses complained, however, that the rules were too complex and would be costly to implement.

Provisions to account for renewal options and contingent rents, or rents that vary with factors such as a store's sales volumes, as part of lease liabilities came in for particularly heavy criticism.

"The message is we heard the concerns and stay tuned," Seidman said.

Businesses had also complained that the proposed changes would cause their reported liabilities to jump, in some cases tripping companies' debt covenants. (Additional reporting by Sarah N. Lynch, editing by Gerald E. McCormick, Gary Hill)

Reuters

[flow5]

WASHINGTON — The 2008 financial crisis was an “avoidable” disaster caused by widespread failures in government regulation, corporate mismanagement and heedless risk-taking by Wall Street, according to the conclusions of a federal inquiry.

The commission that investigated the crisis casts a wide net of blame, faulting two administrations, the Federal Reserve and other regulators for permitting a calamitous concoction: shoddy mortgage lending, the excessive packaging and sale of loans to investors and risky bets on securities backed by the loans.

“The greatest tragedy would be to accept the refrain that no one could have seen this coming and thus nothing could have been done,” the panel wrote in the report’s conclusions, which were read by The New York Times. “If we accept this notion, it will happen again.”

While the panel, the Financial Crisis Inquiry Commission, accuses several financial institutions of greed, ineptitude or both, some of its gravest conclusions concern government failings, with embarrassing implications for both parties. But the panel was itself divided along partisan lines, which could blunt the impact of its findings.

Many of the conclusions have been widely described, but the synthesis of interviews, documents and testimony, along with its government imprimatur, give the report — to be released on Thursday as a 576-page book — a conclusive sweep and authority.

The commission held 19 days of hearings and interviews with more than 700 witnesses; it has pledged to release a trove of transcripts and other raw material online.

Of the 10 commission members, the six appointed by Democrats endorsed the final report. Three Republican members have prepared a dissent focusing on a narrower set of causes; a fourth Republican, Peter J. Wallison, has his own dissent, calling policies to promote homeownership the major culprit. The panel was hobbled repeatedly by internal divisions and staff turnover.

The majority report finds fault with two Fed chairmen: Alan Greenspan, who led the central bank as the housing bubble expanded, and his successor, Ben S. Bernanke, who did not foresee the crisis but played a crucial role in the response. It criticizes Mr. Greenspan for advocating deregulation and cites a “pivotal failure to stem the flow of toxic mortgages” under his leadership as a “prime example” of negligence.

It also criticizes the Bush administration’s “inconsistent response” to the crisis — allowing Lehman Brothers to collapse in September 2008 after earlier bailing out another bank, Bear Stearns, with Fed help — as having “added to the uncertainty and panic in the financial markets.”

Like Mr. Bernanke, Mr. Bush’s Treasury secretary, Henry M. Paulson Jr., predicted in 2007 — wrongly, it turned out — that the subprime collapse would be contained, the report notes.

Democrats also come under fire. The decision in 2000 to shield the exotic financial instruments known as over-the-counter derivatives from regulation, made during the last year of President Bill Clinton’s term, is called “a key turning point in the march toward the financial crisis.”

Timothy F. Geithner, who was president of the Federal Reserve Bank of New York during the crisis and is now the Treasury secretary, was not unscathed; the report finds that the New York Fed missed signs of trouble at Citigroup and Lehman, though it did not have the main responsibility for overseeing them.

Former and current officials named in the report, as well as financial institutions, declined Tuesday to comment before the report was released.

The report could reignite debate over the influence of Wall Street; it says regulators “lacked the political will” to scrutinize and hold accountable the institutions they were supposed to oversee. The financial industry spent $2.7 billion on lobbying from 1999 to 2008, while individuals and committees affiliated with it made more than $1 billion in campaign contributions.

The report does knock down — at least partly — several early theories for the financial crisis. It says the low interest rates brought about by the Fed after the 2001 recession; Fannie Mae and Freddie Mac, the mortgage finance giants; and the “aggressive homeownership goals” set by the government as part of a “philosophy of opportunity” were not major culprits.

On the other hand, the report is harsh on regulators. It finds that the Securities and Exchange Commission failed to require big banks to hold more capital to cushion potential losses and halt risky practices, and that the Fed “neglected its mission.”

It says the Office of the Comptroller of the Currency, which regulates some banks, and the Office of Thrift Supervision, which oversees savings and loans, blocked states from curbing abuses because they were “caught up in turf wars.”

“The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire,” the report states. “The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand and manage evolving risks within a system essential to the well-being of the American public. Theirs was a big miss, not a stumble.”

The report’s implications may be felt more in the political realm than in public policy. The Dodd-Frank law overhauling the regulation of Wall Street, signed in July, took as its premise the same regulatory deficiencies cited by the commission. But the report is sure to be a factor in the debate over the future of Fannie and Freddie, which have been run by the government since 2008.

Though the report documents questionable practices by mortgage lenders and careless betting by banks, one striking finding is its portrayal of incompetence.

It quotes Citigroup executives conceding that they paid little attention to mortgage-related risks. Executives at the American International Group were found to have been blind to its $79 billion exposure to credit-default swaps, a kind of insurance that was sold to investors seeking protection against a drop in the value of securities backed by home loans. At Merrill Lynch, managers were surprised when seemingly secure mortgage investments suddenly suffered huge losses.

By one measure, for about every $40 in assets, the nation’s five largest investment banks had only $1 in capital to cover losses, meaning that a 3 percent drop in asset values could have wiped out the firm. The banks hid their excessive leverage using derivatives, off-balance-sheet entities and other devices, the report found. The speculative binge was abetted by a giant “shadow banking system” in which the banks relied heavily on short-term debt.

“When the housing and mortgage markets cratered, the lack of transparency, the extraordinary debt loads, the short-term loans and the risky assets all came home to roost,” the report found. “What resulted was panic. We had reaped what we had sown.”

The report, which was heavily shaped by the commission’s chairman, Phil Angelides, is dotted with literary flourishes. It calls credit-rating agencies “cogs in the wheel of financial destruction.” Paraphrasing Shakespeare’s “Julius Caesar,” it states, “The fault lies not in the stars, but in us.”

Of the banks that bought, created, packaged and sold trillions of dollars in mortgage-related securities, it says: “Like Icarus, they never feared flying ever closer to the sun.”

[flow5]

Rand Paul follows through on campaign promise, files bill calling for audit of Federal Reserve


FRANKFORT, Ky. (AP) - Republican U.S. Sen. Rand Paul of Kentucky has followed through on a campaign promise by filing legislation calling for a full audit of the Federal Reserve.

Paul filed the bill Wednesday. It is similar to a measure pushed by his father, Republican U.S. Rep. Ron Paul of Texas.

Republican Sens. Jim DeMint of South Carolina and David Vitter of Louisiana signed on as co-sponsors of Paul's bill.

Paul, who said during his campaign last year that he would push for an audit of the Federal Reserve, said Wednesday the agency's monetary policies need a critical look.

The bill would remove restrictions now in place that prevent the Government Accountability Office from conducting Federal Reserve audits.

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We want a full report.

[flow5]

Gold's being hit by the seasonals. Time to sell short. Their running a special (1) higher interest rates & (2) lower reserves.

[flow5]

Global food prices and inflation targetingLuis AV Catão Roberto Chang
27 January 2011


Rising food prices once again pose central banks a tricky question. How far should they ignore food price inflation? This column suggests that food tends to have stronger predictive power on global inflation cycles than oil. The problem is more severe in emerging markets where consumption basket weights for food are two or three times larger than in rich nations. Central banks should pay close attention.


The uneven recovery in advanced countries is hiding an issue that, while off the agenda in the last G20 meeting back in November, is arguably no less urgent for the global economy – namely, the rise in food prices.

•Following a steep acceleration initiated last summer, global food prices (as measured by the IMF global food price index) rose by 21% in the year leading up to November 2010 (latest available figure).
•Global average food prices are now back to their pre-crisis peak, despite a collapse in the wake of the 2008/09 financial crisis,
Coupled with the most recent round of weather setbacks and slashes in key crop forecasts worldwide, there is little hope that such inflationary pressures will abate. If anything, the US and EU economic recovery will exacerbate them.

In advanced countries, these developments have not yet percolated through the inflation outlook, which remains broadly dormant due to offsetting effects of falling manufacturing prices and continuing slack in labour markets. But this isn’t so elsewhere.

•In emerging markets, non-trivial deviations from targeted inflation have begun to emerge.
•Food price sub-indices are well ahead of headline inflation, often two to three times as fast.
This is particularly alarming insofar as much of the acceleration in food inflation in emerging markets comes from basic staples such rice and corn, with seemingly limited scope for substitutability in consumption baskets.

In Indonesia, for instance – where per capita rice consumption is higher than the Asian average – rice prices were up by as much as 30% in the year to December. Subsidies and tariffs, meanwhile, have mitigated the external price pass-through only to a limited extent elsewhere in the continent. From Jakarta to Mexico City, stories of rising imports making up for significant shortfalls in the domestic supply of such staples continue to abound.

With food typically weighing 20% to 50% in national consumption baskets in developing countries, as opposed to 12% to 15% in core advanced countries (see Table 1), this “decoupling” in the inflation outlook is hardly surprising. But it does not make the issue of global food inflation any less critical looking forward.

While longer-term price projections for some these staples portray a bright picture for many emerging markets in terms sustainable terms-of-trade gains over the current decade (OECD-FAO 2010), the ongoing acceleration in food prices creates important dilemmas for monetary policy in net food exporters and importers alike over the near term.

Food inflation more important than oil price risesHistory is adamant on the risks. While much has been made of oil prices as drivers of global inflationary spurts since the 1970s, recent work of ours (Catão and Chang 2010) provides evidence that food price pressures have been no less important. The data in fact suggests that food tends to have stronger predictive power on global inflation cycles than oil.

As Figure 1 illustrates, every single inflation upturn over the past four decades has been preceded (with a one to two-year lag) by an uptick in world food prices; this causality relation is confirmed by formal econometric tests. To be sure, one could arguably blame such past slippages on the looser monetary regimes of the 1970s and 1980s. Yet, later experience indicates that this transmission mechanism remains quite alive in the more recent era of inflation targeting too.

This is portrayed in Figure 2, which plots the IMF global indices of food and oil prices (measured along the left vertical axis) against the cross-country median of percentage deviations from the central inflation targets (measured along the right vertical axis) for all countries that have formally adopted inflation targeting. Clearly, the large swings since 2006 in deviations of actual from targeted inflation have coincided with attendant swings in world food prices. Further, Figure 2 also confirms that food prices are better predictors of global inflation than oil prices. While oil prices began to climb up in earnest from 2003, significant deviations from targeted inflation only materialised after food prices took off from late 2006. In short, there is substantial evidence – both recent and well-past – that food prices lurk behind large international swings in inflation rates.

Figure 1.

www.voxeu.org/index.php?q=node/6054

Figure 2.



Against this background, a key question to national central banks is the extent to which such imported inflation should be accommodated. In the case of large central banks like the ECB and the US Federal Reserve, two considerations stand out.

•The first is that their actions have a direct bearing on global food price given their weight in world income and capacity to set world interest rates, influencing food prices via both demand and supply channels.
•The second is that their actions have strong externalities elsewhere. In the emerging/developing world, this can be far-reaching because food accounts for a very high share in consumer spending and, since much of it consists of non high-end items, it cannot be substituted away.
Well-known structural weaknesses of developing countries add to the problem. Soaring food inflation can trigger far-reaching unrest wherever political institutions are fragile, financial systems are less mature to smooth out shocks, and social safety nets inadequate, as witnessed by the many food-related riots during 2007-08.

What should monetary policy do?
A situation that deserves special consideration is that of the worst sufferer – the price-taking small-open economy that is a net food importer with a share of food in the national consumption basket far larger than that of the advanced world. In that case, our work (Catão and Chang 2010) indicates that monetary authorities should not accommodate the attendant rise in CPI inflation even if they do not practice price level targeting. In fact, among the policy rules usually adopted by central banks, the strict targeting of broad CPI inflation is often the best for domestic welfare.

In other words, setting monetary policy on the basis of CPI inflation stripped from its commodity price sub-indices, or targeting domestic producer inflation, is less advisable. This is so because CPI targeting strikes a better balance between stabilising the real exchange rate, which in turn helps stabilise domestic consumption, and keeping domestic producer inflation under control without over compressing it.

The reason it is desirable to stabilise domestic producer costs (and hence prices) is that not all producers in this small open economy are free to set prices at any moment, which distorts relative prices across producers, which is sub-optimal. This is more critical the more persistent the food price shocks; and the empirical evidence suggests that such shocks are typically very persistent.

Completely stabilising domestic prices, however, is not desirable because it robs some latitude from domestic producers, given imperfect international arbitrage in goods markets, to raise prices, which will be partly paid for by the foreign consumer. Allowing domestic prices to be set a bit higher on average as a reaction to volatile food prices (and hence to volatile wages and costs), the small-economy policymaker makes more effective use of the so-called “terms of trade externality”.

Finally, as greater real-exchange-rate stabilisation also helps stabilise the purchasing power of food-intensive consumption baskets, the distributive consequences of CPI inflation targeting are less dire than those of producer price inflation targeting. This is particularly relevant for countries with highly skewed income distribution and inadequate social safety nets. So, as with some of the literature on oil price shocks (see e.g. Batini and Terenu 2010; Blanchard and Gali 2007 and references therein), the above considerations make a case for a non-accommodating policy stance toward imported food inflation.

Yet, judged by standard estimates of the Taylor rule, strict adherence to broad CPI targeting appears to have been the exception and not the rule during rampant food inflation in 2007-08. To the best of our knowledge, this observation has not gained due currency in policy circles and/or among market observers and, yet, is readily apparent.

Table 2 reports regressions of the policy interest rate on its first-order lag, the HP-filtered output (“ygap”), and on current CPI inflation (“CPI inf”). Because central inflation targets move over time in some countries, both the interest rate and the inflation rate are measured as deviations from the central inflation target. Finally, the set of explanatory variables includes the interaction of inflation with a dummy which equals 1 during the food price hike of 2007Q1-2008Q3 and zero otherwise. A negative coefficient on this interaction term indicates that policy rates were set lower in 2007Q1-2008Q3 than they should have been, relative to the average reaction. That coefficient is negative in all Table 2 countries except New Zealand; it is also statistically significant at 10% or less in half of them. This is all the more surprising in light of evidence that food price shocks tend to be highly persistent and that monetary policy operates with long lags, particularly in advanced countries. One might expect these two considerations to trigger a more prompt and aggressive response to the 2007-08 hike.

Table 2. Descriptive Taylor rule estimates



This apparent leniency in individual policy responses – at least when measured relative to standard Taylor rule baselines – had global implications. World real interest rates would otherwise have been higher, which in turn would have helped dampen commodity prices and possibly contain the widening in global imbalances. Higher world interest rates at the onset of the crisis would also have given central banks more latitude for subsequent easing, possibly obviating widespread resort to heterodox measures like quantitative easing.

Policy lessons
Going forward, what lessons can we take from this evidence?

•First and foremost, global food price pressures pose a sizeable threat to global monetary stability.
•Second, they pose an externality problem that demands non-trivial coordinated action by key central banks.
Left alone, we should fear that coordinated action may come in too little and too late because the inflation spillovers are largely felt first in emerging markets (again, much due to higher food shares in consumption baskets) and because individual advanced societies are better equipped to withstand such a price shock at least for a while. So, the associated policy prescription is hardly “one-size-fits all”. These various considerations suggest that strict and widespread targeting of broad CPI inflation, while not a silver bullet, does help.

To be sure, the more aggressive interest rate reaction to imported food inflation demanded by broad CPI inflation targeting raises well-known problems of its own for the small open economy, particularly regarding capital inflows. Standard macro models featuring complete international capital markets and frictionless domestic financial intermediation are ill-suited to address these problems. While developments in this area of research are promising, they still fall short of offering clear-cut prescriptions to policy makers. Absent that, the targeting of broad CPI inflation, when consistently implemented, appears to be a stronger contender than other rules in terms of mitigating monetary policy externalities on a global basis and helping keep global inflationary pressures at bay.

The views expressed in this article are the sole responsibility of the authors and should not be attributed to the International Monetary Fund, its Executive Board, or its management.

References
Batini, Nicoletta and Eugene Tereanu (2010), “Inflation targeting during asset and commodity price booms”, Oxford Review of Economic Policy, 25:15-35.

Blanchard, Olivier and Jordi Gali (2007), “The macroeconomic effects of oil shocks: why are the 2000s so different from the 1970s”, NBER Working Paper13368.

Catão, Luis AV and Roberto Chang (2010), “World food prices and monetary policy”, NBER Working Paper 16563.

OECD-FAO (2010), Agricultural Outlook 2010-2019, Paris.
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Totally agree